Is a long-term capital gains tax on equity a bad idea?

New Delhi, Jan. 3 -- The feeding frenzy on the possibility of long-term capital gains tax coming to equity for a while with editorials and TV shows hand-wringing about the retail investor getting hurt. But will we? Is a long-term capital gains tax on equity such a bad idea? Let's get the basics out of the way first. The money we invest in different assets (bank fixed deposits or FDs, bonds, gold, real estate, equity and into some of these through mutual funds and bundled life insurance plans) throw off money in different forms. There is rent, interest and dividend that comes as income from an asset. This is income from owning and using an asset-financial (stocks, FDs and bonds) or real (gold and real estate). When you sell the asset you can either make a profit or a loss. Profits on sale of assets are called capital gains and in India are taxed under two heads-short-term and long-term.
How long is short-term? Both short-term and long-term are defined in different ways for different asset classes (see table to understand this better). Not only is short-term different for different assets, the tax rates vary too. In the table we see the preferential treatment given to equity over bonds, real estate and gold. The asset becomes long-term if you hold it for a year; for others, the period is 3 years.
The tax rates, too, favour equity, with zero taxes to be paid on profits if you hold it for more than a year. India used to tax capital gains on equity till 2003-04, when the then finance minister Jaswant Singh (http://mintne.ws/2hFn4AW) proposed to abolish it for securities held for more than a year. This was to be reviewed in a year. The next budget in 2004-05 was presented by P. Chidambaram, who carried forward the idea and imposed a securities transaction tax (STT) to make up the tax loss (http://mintne.ws/2iotvfT).
Economist Ajit Ranade has a good column in Mint (http://bit.ly/2i4Ew5J) on why this distortion came into the Indian market and how the reason (preferential tax treatment to Mauritius) is now gone, paving the way for removal of STT and reintroduction of a long-term capital gains tax. Also read IIM-Ahmedabad professor Jayant R. Varma's 2006 blog on why this is a bad idea. You can read it here: http://mintne.ws/2iupHrn.
As the table shows, the problem with the current tax structure is at three levels.
One, there is a lack of parity in the definition of what is long-term. We should have one set of rules for the market and the differences should be removed, unless there is a logical argument to keep status quo. Whether the government hikes it to 3 years for equity or reduces others to 1 year is its call.
Two, there are different tax rates for different products and these differential tax rates are unreasonable. Today, we tax long-term capital gains from a bond at rates higher than we do for a stock. People who want lower risk to their portfolios are skewed more towards bonds. Those with higher equity allocation are usually better off and able to take the higher risk. Such people pay lower taxes. We need to re-examine this.
Three, there is no parity in the vehicles that retail investors use to approach bond and stock markets-mutual funds and life insurance products. Life insurance policies, through unit-linked insurance plans, invest in the same stocks and bonds that mutual funds do. Why then the lack of parity in taxation? Endowment plans invest in government bonds; they, too, should be taxed at par with other listed bonds. If the tax nudge was there to encourage people to buy insurance, then this is the wrong route because what is being sold is not risk cover but expensive bundled investment. If the goal is to encourage long-term retail participation in equity, make the zero-tax status on money that stays for, say, 10 years. Only if you hold equity for 7-10 years, do you get the benefit of long-term growth. This period usually smoothens out business cycles. Retail investors should not be in equity with a 1-year horizon. Equity works over the long term and giving a tax-free status after just 1 year is wrong messaging.
With a tax break for holding the asset for the long term, investors get a nudge to holding on longer. Make switching between listed securities tax-free. So, if fund A is misfiring, I should be able to move to fund B without paying tax. Make it open between equity, gold, real estate and bonds that are listed on an exchange and accessible to a retail investor through an institution such as the National Pension System (NPS), mutual fund or Ulip. Only on redemption before 10 years should I get the tax liability.
End note: The reaction to just the thought of a long-term capital gains tax shows that any change that hurts us is painful. Remember the way we reacted to a tax proposal on our pension funds? Every reform will hurt somebody or the other. We should notice our own reactions to change when it comes near us before we ask for big bang reforms that the government needs to make, or opine on how others should respond to change.
Monika Halan works in the area of consumer protection in finance. She is consulting editor Mint, consultant NIPFP, and on the board of FPSB India. She can be reached at monika.h@livemint.com